It's been a rocky month for the stocks. While no one likes volatility, recent moves have helped right what has been a seriously out-of-whack stock market. The market's new, more stable posture could set up investors for further gains later this year.
Stocks seemed to be on a tear in 2024. After leaping nearly 19% to a record on July 16, the S&P 500 hit a wall this month -- including posting its biggest down day in more than a year last week. On Monday, the index was up 0.06%, or 3 points to 5,462.
One factor has been wild turns in the U.S. presidential election, which saw one candidate dodge an assassination attempt on July 13, and another drop out just over a week later. But perhaps an even more important are concerns that tech companies' ultimate AI profits might not live up to sky-high stock prices. The so-called Magnificent 7 tech stocks, which have powered the market for the past few years, are down nearly 12% from their mid-July peak.
Fortunately, for investors that big stumble hasn't led to talk of a bear market or even a correction. Instead, the word on Wall Street's lips has been "rotation."
While tech was taking it on the chin, long out-of-fashion small cap stocks posted a dramatic rally, with the Russell 2000 returning 12% since the start of the month. Underperforming large-cap sectors like real estate, materials and utilities have also done well. "A full-fledged bear market is unlikely," concluded a Bank of America Securities research note Monday. "Rotation is where the action is."
The market's overall resilience shouldn't necessarily come as a surprise. Last week the U.S. economy posted surprisingly strong GDP numbers. More than three-fourths of companies to report second-quarter earnings have beat analysts forecasts. And, the inflation picture appears to have stabilized, giving investors increasing confidence the Fed will undertake one or more rate cuts starting in September.
Investors should see the rotation as a stroke of luck -- and root for it to continue. It should allow the tech sector -- which had become a dangerously swollen presence in the market -- to right-size itself without leading to the kind of market-wide wipeout that followed the 1990s dot-com bubble.
That's already started to happen. Just this month the Magnificent 7's share of the S&P 500's total market capitalization has fallen to 31.6% from 34.4%, according to independent markets researcher Jim Paulsen. While still high, that's much closer to the more sustainable 30% level where it had hovered before surging ahead this year, he notes.
A mirror-image of this dynamic appears likely to be at play with small caps. Earlier this year small caps's share of the broad-market Russell 3000 had fallen to a 20-year low 5.2% from a high of nearly 9% in 2006. As of Friday, small caps share had returned to around 6%, according to FactSet.
How to position yourself going forward? One simple step is to check your index funds. For the past month, the Vanguard Total Stock Market ETF returned 0.7%, almost a percentage-point better than the Vanguard S&P 500 ETF, which has declined 0.2%. The broader fund has 8% of its assets invested in small-cap stocks, compared to less than 1% for the S&P 500 option.
The lesson may seem obvious but it seems plenty of investors haven't learned it. The $409 billion Vanguard Total Stock Market ETF is the fourth-largest exchange-traded fund on the market, according to data company VettaFi. The top three are all S&P 500 funds that collectively hold more than $1.5 trillion. (To be fair it's likely some, although not all, investors who own S&P 500 funds are institutions or pair them with separate small-cap ETFs.)
Investors who want to take a bigger, more active bet on the rotation can go with an equal weight ETF, such as the Invesco S&P 500 Equal Weight ETF, which downplays tech's role in the market by weighing every company in its portfolio the same. And, of course, there are small cap funds like Vanguard Russell 2000 ETF or the iShares Core S&P Small-Cap ETF, which screens holdings for profitability.
Still, there are risks to chasing returns. With small cap stocks having already jumped 10% in recent weeks, it's unlikely they will repeat their feat, even if the economy continues to hum along. As long as you aren't too tech heavy, and you have at least some exposure to small caps, the best way to readjust your portfolio for the rest of year may simply be to let it readjust itself.
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